Page 1 of 3 CREDIT BUBBLE BULLETIN About a half paradigm
Commentary and weekly watch by Doug Noland
There were key developments last week providing added confirmation to my macro
thesis. First of all, the dismal payroll data (10.2% unemployment!) - after a
year of unprecedented fiscal and monetary stimulus - confirm the depth of
structural impairment overhanging US recovery. Our economy is badly lagging the
globe's rebound.
Over some months, I have worked to construct a framework for analyzing the
unfolding global reflation. I've been expecting this reflation to unfold with
altogether different dynamics than previous reflationary periods. After
watching developments, I am willing to go so far as to argue that we are
witnessing a historic paradigm shift. The most robust credit dynamics have
shifted from the
"core" (US) to the "periphery" - with major ramifications. This atypical global
reflationary backdrop is dictated by the emergence of a global government
finance bubble and dynamics that support powerful financial flows to non-US
markets and economies.
Previous bouts of reflation were powered primarily by Wall Street credit,
specifically mortgage finance, securitizations and speculative leveraging. From
an economic perspective, US housing, consumption and the
credit/asset-inflation/consumption-based US bubble economy were at reflation's
heated epicenter. From the perspective of global speculative financial flows,
dollar-denominated securities markets were consistently and predictably the
asset market demonstrating the most robust inflationary biases (global
financial players had to participate).
Like clockwork, systemic stress would eventually provoke the activist Federal
Reserve into slashing rates, inciting higher (dollar) securities prices, and
promoting speculative leveraging. This incredible mechanism would immediately
inject cheap liquidity directly into US housing and, only somewhat delayed,
throughout the general economy. The vulnerable dollar persevered through the
generosity of global flows attracted to the inflationary biases percolating
throughout US securities and asset markets (with the Fed and
government-sponsored enterprises (GSEs) acting as powerful market liquidity
backstops).
The bursting of the Wall Street/mortgage finance/housing bubbles forever
altered key dynamics. Importantly, the private-sector US credit system lost its
status as the epicenter of global credit expansion and speculation. Wall Street
and US mortgage finance "inflationary biases" were displaced - hence the
termination of their role as powerful monetary stimulus mechanisms.
Indeed, years of dollar debasement had come home to roost. Non-dollar (that is
global currencies, gold/precious metals, energy, commodities, China, India,
Asia, Brazil and the emerging markets) assets supplanted US securities as the
asset class demonstrating the most enticing upward/inflationary bias. These
days, activist Fed monetary looseness lavishes liquidity first and foremost out
to the periphery.
The front page of Wednesday's Financial Times included two notable headlines:
Next to "Buffett bets $26bn on US" was "India sells dollars for gold and lifts
bullion to high". I certainly view the Reserve Bank of India's purchase of 200
tonnes of bullion from the International Monetary Fund as exemplifying the
profound shift of financial power from the core to the periphery - as well as
the shift of "inflationary biases" from dollar securities to "undollar" asset
classes.
The Indians today enjoy the financial resources, and they are apparently eager
to trade dollar holdings for hard - non-dollar - assets. And as much as the
media trumpeted Mr Buffett's railroad acquisition as a vote of confidence for
US recovery, there's surely more to his analysis. In the unfolding paradigm
shift, the US "services" economy will have no alternative than to adjust to a
more efficient goods-producing economic structure.
Our troubled currency will require that we produce more, consume less, survive
on reduced amounts of credit - and we will have to do so in an energy-efficient
manner. Within such a backdrop, the railroad business would be relatively
appealing when compared with consumer-based businesses or US financial assets
more generally. I would also view Mr Buffett's aggressive move as supporting
the thesis of hard assets supplanting dollar securities as the preferred asset
class.
Disappointingly, the Federal Reserve last week also confirmed my macro
analysis. The Ben Bernanke-led Fed has now locked itself into a policy course
that will ignore global reflation dynamics and instead fixate on specific US
economic indicators. Instead of adopting a more hawkish posture and laying the
market groundwork for withdrawing extraordinary monetary stimulus, the Fed flew
even farther into uncharted dovishness. This adds to a long series of
(compounding) errors from our central bank. Most importantly, the Federal
Reserve signaled "resource utilization" (markets read "unemployment rate") as a
key factor that will determine the course of policy normalization. If I had to
choose one economic indicator guaranteed to notably lag global reflationary
dynamics, well, I'd bet on US payrolls.
So, from a macro perspective, a clearer view is coming into focus - a new
paradigm is emerging. New global reflationary dynamics have gained important
momentum. Credit systems in China, India, elsewhere in Asia, Brazil and the
developing world - the "periphery" - are today significantly more robust than
they are here at home (the "core"). Powerful global financial flows to the
inflating periphery ("monetary processes") also work to ensure market and
economic outperformance.
The rising periphery - with its billions of consumers and rising demand for
commodities - has realized a robust and self-reinforcing inflationary bias.
Moreover, secular dollar weakness has increased the investment and speculative
merits of commodities and other hard assets when contrasted to dollar
securities. Dollar weakness begets global reflation that begets dollar
underperformance that begets a new paradigm.
The balance of financial and economic power has shifted decisively away from
the US; the periphery has supplanted the core as the epicenter of global
economic reflation, recovery, and expansion. Yet the more the world changes,
the more the Fed remains the same. Disregarding both the impaired dollar and
global reflationary dynamics, the Fed has locked itself into pegging rates
based singularly on dismal US economic fundamentals. These ultra-low core rates
are providing a very hefty global interest-rate anchor.
I will humbly suggest that a momentous global economic transformation is at
this point about half a paradigm. Powerful global economic and inflationary
forces have decisively shifted to the periphery. Meanwhile, the Federal Reserve
(core) still retains remarkable dominance over global market yields. I believe
we are in a transition period, with the Fed's power over global yields waning
over time (or perhaps abruptly in a future crisis backdrop). In the meantime,
however, global yields are mismatched to the reflationary backdrop. This
predicament implies ongoing market distortions, a rather extraordinary global
mispricing of the cost of finance, along with all the myriad financial and
economic costs associated with unrelenting "monetary disorder" (that is, asset
bubbles, imbalances, mal- and over-investment, financial and economic
fragilities, and so forth.)
Of late, there's some loud clamoring with respect to the dollar carry trade and
global asset bubbles. Little doubt the "carry trade" (borrowing at low rates in
the US to play higher-yielding assets globally) is a meaningful source of
global liquidity, although it should not be overstated in the context of rapid
synchronized periphery credit growth. And, clearly, speculative excess has
found its way to "developing markets" (some years ago I would write "liquidity
loves inflation" to describe how financial flows inherently gravitate toward
the inflating asset classes).
But I would stress that a reasonable portion of this year's spectacular market
gains are associated with a fundamentally based revaluation of periphery and
commodity-based assets. There's more to this year's global market moves than
mindless buying of risk assets and bubble excess. Furthermore, I believe the
core-to-periphery dynamic is a secular trend that will prove less vulnerable to
bursting bubbles than others would contend.
The sources of acute systemic fragility are generally not easily or commonly
recognized during periods of excess. The risks wrought from Fed-induced market
distortions and mis-pricings during the mortgage finance bubble were not
apparent to most until it was much too late. The perception today is that our
post-bubble systemic backdrop is not vulnerable to either excesses or
inflationary pressures. The bulls scoff at the notion that there are domestic
risks associated with sticking with ultra-easy monetary policy (any one catch
Paul McCulley's CNBC interview late last week?). The risks are there but not so
visible.
A major yet unappreciated domestic risk associated with Fed policy is that
ultra-low interest-rates are being only further embedded into credit and
economic structures. The Fed has manipulated short-rates and market yields in
the most extreme degree. This intervention has amounted to massive distortion
throughout the markets, while this process has further spurred the paradigm
shift of power from the core to the periphery.
Each month, the US credit system and economy become only more vulnerable to a
rise in yields (mortgage and Treasury borrowing costs, in particular). Imagine
the US housing market in an environment of much higher mortgage rates and then
ponder the scope of the Fannie Mae/Freddie Mac/Federal Home Loan Bank/Federal
Housing Administration bailouts in the event of a spike in yields. Picture the
dilemma faced by the US Treasury if its borrowing costs jump significantly. How
about the fiscal position of state and local governments? Could our frail
banking system handle a surprise rise in rates? And imagine the corner
policymakers would find themselves boxed into when the Fed loses control over
market yields.
It is not clear to me whether it will unfold over months or years. But I do
expect a more complete paradigm shift to foster waning influence of the Fed
over global market yields commensurate with fading US economic dominance.
Unless global reflationary forces dissipate, this implies a future adjustment
period for US interest-rate and risk asset markets. And when the Fed eventually
loses command over market yields, the risks associated with today's policy
course will likely manifest into a very problematic financial and economic
crisis.
The Fed should neither peg interest rates nor telegraph the future course of
interest rate manipulations - especially at near zero rates. And the Fed can
today ignore global reflationary dynamics at our - and the US currency's -
future peril. It's amazing the lessons somehow not learned.
WEEKLY WATCH
For the week, the S&P500 jumped 3.2% (up 18.4% y-t-d), and the Dow rose
3.2% (up 14.2%). The Morgan Stanley Cyclicals surged 5.8% (up 57.7%), and
Transports shot 6.6% higher (up 8.9%). The Morgan Stanley Consumer index rose
2.5% (up 18.1%), and the Utilities increased 1.7% (down 2.4%). The Banks
climbed 1.4% (down 3.3%), and the Broker/Dealers gained 2.6% (up 48.1%). The
S&P 400 Mid-Caps rallied 3.4% (up 26.6%), and the small cap Russell 2000
rose 3.1% (up 16.2%). The Nasdaq100 jumped 3.8% (up 42.8%), and the Morgan
Stanley High Tech index gained 3.4% (up 56.7%). The Semiconductors increased
1.7% (up 42.2%). The InteractiveWeek Internet index jumped 3.4% (up 64.1%). The
Biotechs rallied 8.4% (up 37.6%). With bullion surging $50, the HUI gold index
jumped 13.1% (up 46.2%).
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